After a stellar year in 2013, the S&P 500 got off to a rocky start in 2014, dipping over 4% in January. By the end of the quarter, however, prices recovered and investors earned positive returns in both stocks and bonds. In the U.S., bad weather stifled economic growth but investors are anticipating higher levels of activity, particularly in the housing sector, after the winter thaw. Geopolitical concerns, including the conflict in Ukraine and mixed growth among emerging market countries, rattled investor confidence periodically during the quarter. After two years with relatively low stock price volatility, this quarter gave us a brief reminder of the uncertainty we must endure to achieve the long‐term returns available from stocks.
A few of the asset classes most out‐of‐favor in 2013 provided the highest returns during the first quarter. Commodities were one of the best performing investments, with agricultural products posting the largest gains. Drought concerns in portions of the U.S. increased the possibility of rising food prices this summer. Precious metals rose during the quarter, too, with speculation that investors wanted to own gold as a safe haven, fearful that the political upheaval in Ukraine would grow beyond the borders of Crimea. Emerging markets continued to underperform with political tensions in a number of regions. Concerns about China’s banking system led to tighter access to capital and increased expectations for slowing growth in the future. China also experienced its first corporate bond default during the quarter.
In February, Janet Yellen debuted as the new head of the Federal Reserve. She provided few surprises to the markets, supporting the pace of monetary tightening. Somewhat disappointing economic data in the U.S. led investors to believe that easy money policies are likely to remain for some time, keeping a lid on interest rate increases. Bonds and other interest‐rate sensitive sectors, including REITs and utilities, rallied during the quarter as interest rates declined. Tensions in Ukraine led investors to seek safe haven in U.S.‐dollar denominated assets, which also pushed bond prices higher.
Municipal bonds performed better than other fixed income sectors as interest rates declined and low levels of issuance constrained supply. While new high‐quality issues were sparse, Puerto Rico issued $3.5 billion of debt in March, the largest ever junk‐rated municipal deal in history. The sale will help the commonwealth cover its short‐term liquidity needs; however, this doesn’t solve its long‐term fiscal imbalances. Puerto Rico (and other struggling municipalities like Detroit and Stockton) serves as an ongoing reminder of the fragility of poorly‐capitalized borrowers in the municipal market. We continue to favor high‐quality issuers for our clients’ portfolios.
A Little Excitement
It’s been a relatively peaceful time to invest, with volatility much lower than expected. Over the past two years (the first quarter of 2014 included), investors in U.S. stocks have not experienced the typical level of stock price volatility one would expect based on historical patterns of return. According to a recent J.P. Morgan study, the S&P 500 dropped 14.4% intra‐year, on average, since 1980. These drawdowns reversed at some point in the majority of years, with annual returns ending in positive territory in 26 of those 34 years. With recent volatility lower than expected, we need to be prepared for a little excitement.
While it is difficult to identify any one cause for upcoming volatility, one of the most popular theories is that the Federal Reserve has engineered an environment of artificially low rates, forcing investors to take on the risk of owning stocks to achieve returns. As we’ve discussed in this letter previously, we are in a period of unprecedented monetary intervention. The Federal Reserve has purchased over $3 trillion of U.S. Treasury and mortgage bonds to keep interest rates low and stimulate economic activity. The bond buying continues, albeit at a more moderate pace. Stocks have more than doubled since the Fed announced its first bond‐buying program back in 2008. Foreign developed‐market stocks have also done well in an environment of central bank support. Meanwhile, economic growth, while positive, has not been robust, especially when we consider the recovery we could have experienced after the severe recession accompanying the financial crisis.
Some believe that stock valuations have become more expensive relative to earnings as investors purchase equities without regard for valuation, searching for return in a low interest rate world. One measure of valuation, Robert Shiller’s cyclically‐adjusted price‐earnings (CAPE) ratio, is currently 25 times the 10‐year average of corporate earnings, compared to the long‐term average of 16.5 times earnings. But, as we know, one data point does not prove cause and effect. The CAPE ratio has persisted at relatively high levels for significant time periods in the past. Other methods of valuation indicate more reasonable stock prices. S&P 500 operating earnings were at an all‐time high in the fourth quarter of 2013, providing persuasive support for current valuations.
It is possible that the link between low interest rates and a robust stock market is more fundamental. When interest rates are low, the cost of doing business declines. Businesses can borrow for expansion (or more recently, to hoard cash) at very low rates. Consumers can purchase homes and lock in affordable long‐term mortgage rates. They can hire contractors and buy new furniture, stimulating economic activity. This, in turn, helps corporate earnings. With a little luck, this virtuous cycle continues without creating inflation. Unexpectedly low levels of inflation have prevailed over the past few years, even though we have experienced high levels of monetary easing.
Prospectively, investors always face a long list of worries and current valuations are just one of the potential causes of future volatility. With the financial crisis in our recent past, unimaginable events now seem possible. What we do know for sure is that we cannot time the markets well enough to avoid volatility. As a result, investor risk tolerance is a key consideration when constructing portfolios. Your BOS team is prepared to help you navigate the excitement in the future.
Written by Colleen S. Supran, CFA, Principal; [email protected]
|Index||Market||Year-to-Date as of 3/31/14|
|Standard & Poor’s 500||Large Co. U.S. Stocks||1.80%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||3.03%|
|Russell 2000||Small Co. U.S. Stocks||1.12%|
|Russell 2000 Value||Small Co. Value U.S. Stocks||1.78%|
|FTSE NAREIT Equity REIT||Real Estate Investment||8.52%|
|NASDAQ 100||Technology Stocks||0.10%|
|MSCI EAFE1||Foreign Stocks||0.66%|
|Barclays Capital Aggregate||U.S. Dollar Bonds||1.84%|
|Barclays Capital Municipal||Municipal Bonds||3.32%|
|BofA Merrill Global Gov’t Bond||Global Bonds||2.30%|
Key economic indicators compiled by Barbara A. Ziontz, CFP, Portfolio Manager; [email protected]
Data Sources: The Wall Street Journal; US Dept. of Commerce ‐ Bureau of Economic Analysis; US Dept. of Labor; Bloomberg.com; Live.Lehman.com; MSCI.com; REIT.com; NYTimes.com; StandardandPoors.com; Vanguard.com. ; Dimensional Fund Advisors
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